(Weighted average cost of capital) As a consultant to GBH Skiwear, you have been
ID: 2672008 • Letter: #
Question
(Weighted average cost of capital) As a consultant to GBH Skiwear, you have beenasked to compute the appropriate discount rate to use in the evaluation of the purchase of a
new warehouse facility. You have determined the market value of the firm’s current capital
structure (which the firm considers to be its target mix of financing sources) as follows:
Source of Capital Market Value
Bonds $500,000
Preferred stock $100,000
Common stock $400,000
To finance the purchase, GBH will sell 20-year bonds with a $1,000 par value paying
8% per year at the market price of $950. Preferred stock paying a $2.50 dividend can be
sold for $27. Common stock for GBH is currently selling for $35 per share. The firm
paid a $2 dividend last year and expects dividends to continue growing at a rate of
4% per year into the indefinite future. The firm’s marginal tax rate is 34%. What
discount rate should you use to evaluate the warehouse project?
Explanation / Answer
Source of Capital Market Value
Bonds $500,000
PreferredStock $100,000
CommonStock $400,000
Market Price of the Bond = $950, Coupon Interest = 8% , Maturity = 20 years
Assume Flotation Cost = 6% of the market price, Par Value of the bond is $1,000
Market Price of the bond =$950
Less: Flotation Cost = $57
----------
Net Market value of bond = $893
-----------
Current Yield of the bond = (Annual Dollar Interest paid /Market Price) * 100%
= (0.08 * $1000 / $893) *100%
= 0.089 (or) 8.9%
So, Cost of debt (k d) = 8.9%
Calculating Cost of Equity (ke): Dividend paid = $2, Share Price = $35 , Dividend growth rate = 4%
Flotation cost = 10% of market price
Market price $35
Less: Flotation cost $3.5
---------
Net Market Price $31.5
---------
P0 = D0 (1+g) / R-g = D1 /R-g
R = D0 (1+g / P0 = (D1 / P0) + g
R = $2 (1+0.04) / $31.5 = ($2.08 / $31.5) + 0.08
R = 0.146 (or) 14.6%, So, Cost of Equity (k e) = 14.6%
Calculating Weighted Average Cost of Capital (WACC):
Weighted Average Cost of Capital (WACC) =(E/V)*ke + (D/V)*kd(1-Tc)
Debt (D/V) = $500,000 / $1,000,000 = 0.5
Equity (E/V) = $500,000 / $1,000,000 = 0.5
(Preferred stock + Common Stock) = ($100,000 + $400,000 = 500,000)
Marginal Tax = 34%
SO, WACC = 0.50 * 0.146 + 0.50 * 0.089 (1-0.34)
= 0.073 + 0.50 * 0.089 (0.66)
= 0.073 + 0.02937
= 0.10237 (or) 10.24%
Discount rate = 10.24%
Related Questions
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.